Beliefs and common sense guide us in making myriad decisions every day. However, because we believe something to be true or judge it to be true based on "common sense", doesn't make it true. A belief can be validated only by testing it with evidence. This blog is neither right nor left, but undoubtedly will annoy individuals across the spectrum who hold unsupported convictions. My hope is that this blog will encourage us to challenge each others' beliefs and, most importantly, our own.

Saturday, June 16, 2012

The Euro Conundrum and the US Dilemma

The European financial crisis has been dragging on for the
past several years without resolution.
Greece is holding an election this Sunday. SYRIZA leader Alexix Tsipras has stated that
if his party gains control of the Greek government that he will unilaterally abrogate
Greece’s bailout agreement with the Troika (European Commission, European Central Bank, and the International Monetary Fund). This action could lead to Greece’s defaulting
on its debt, leaving the Euro zone, and reinstating the drachma as its national currency.
This in turn would lead to a devastating acute
exacerbation of the financial and economic crisis in Greece and risks spread of financial contagion
throughout Europe and the rest of the world.
Regardless of which political party gains control of the Greek
government, the economic situation is so dire that Greece may end up leaving
the Euro zone in any case.

Meanwhile, the interest rate on Spanish ten year bonds rose
to the 7% level last week – which is the threshold at which Portugal, Ireland, and
Greece requested bailouts (Spain is already slated to receive an
initial bailout targeting its banks).
Italian interest rates on ten year bonds rose above 6%. While Greece’s GDP is only $300 billion,
Spain’s GDP is $1.5 trillion, and Italy’s GDP is $2.2 trillion. Spain and certainly Italy are generally
considered too big to be successfully bailed out by the rest of the European Union.

Why has this crisis been so intractable? The basic issue is that the debt levels in a
number of European countries have risen to levels that are unsustainable. At market interest rates these countries
simply cannot pay back their debt - meanwhile their economies are contracting
and unemployment is at astronomical levels.

Countries with their own currencies that have over-borrowed can
solve their acute problem by printing enough money to create inflation so that
they reduce the real level of their debt.
Of course, this policy has to be coupled with structural financial reforms
to reduce borrowing because inflation leads to higher nominal interest rates on
newly issued debt which will simply reignite the problem. The other solution a country can pursue is to
simply default on its debt – as Argentina did in 2001.

Countries in the Euro zone do not have their own
individual currencies. The basic choices in Europe are
thus either:

1) The European Central Bank prints enough Euros to inflate
away a substantial fraction of the existing debt – a policy contrary to its
mandate.

2) Some countries default on their debt. The default might be disguised as a “voluntary negotiated
reduction in debt level” as Greece recently accomplished with its private sector bond
holders (however, this $100 billion write down of debt in combination with
two bailouts have failed to solve the Greek financial crisis). Explicit default on a country’s debt will almost
certainly lead to that country leaving the Euro zone.

3) Some countries leave the Euro zone so that they can
issue their own currencies and inflate away their debt.

4) More bailouts – however the resources of the European Union
and IMF are probably not adequate to do the job. As long as the bailouts are
in terms of new debt that needs to be repaid the bailouts are unlikely to solve the
problem as has been the case to date.

There don’t appear to be any good solutions here. There is a good chance that the financial and
political stresses may lead to a break-up of the Euro zone itself. For example, France has replaced its right of
center prime minister with a Socialist prime minister who has already reduced
the retirement age – which will directly increase the budget deficit. He also is implementing changes to make it
more difficult for companies to fire workers – this will lead to companies
being more reluctant to hire new workers and thus will have the ultimate effect of raising
unemployment and reducing economic growth. France is certainly too big to be bailed out and if in the future it cannot pay its debt it would have to leave the Euro zone which would likely be the end of the Euro project itself.

What about the United States? Our federal debt is currently over $15 trillion and
exceeds 100% of GDP. The US annual deficit is currently $1.35 trillion dollars
so that the debt level will continue to escalate quickly. A debt level of 100% of GDP is approximately the
same level at which the financial condition of Portugal, Ireland, Greece, and
Spain began to fall apart. Fortunately for the US, because the US economy is currently performing
better than most other Western countries and because the US dollar is the world’s
reserve currency, the interest rates on US debt are at historically low levels. Thus the interest cost on the US debt is
still manageable. However, were the
markets to lose confidence in the US government or economy, and interest rates were
to rise substantially, the results could be devastating. For example, if the US had to pay 7% interest
on its debt this year the interest cost would be 1 trillion dollars per year
which would equal 40% of all revenues collected by the US.

The US clearly needs to implement structural reforms to
reduce the deficit. However, in the
short term the US can protect itself by lengthening the maturity of its
debt. The current maturity of US debt is
approximately 5 years. The interest rate on 30 year treasuries is at
a historically low level of 2.7%. The
real interest rate (interest rate minus inflation) is approximately 1%. Converting the US debt to longer term
maturities, and thus locking in the low interest rates over an extended period,
would give the US breathing room to restructure its finances and avoid the risk
of financial catastrophe if markets were to lose confidence in the US and
interest rates on US debt were to rise substantially. However, it is more expedient politically to
keep the maturities on US short: 5 year treasuries currently bear a nominal
interest rate of only 0.7%. Maintaining the maturity of the US debt at
5 years versus 10, 20 or 30 years reduces the current budget deficit but
exposes the US to potential financial catastrophe from future interest rate shocks.